Stock Option Plans for Startups: The choice isn't trivial, ISOs vs NSOs

US Stock Option Plans for Tech Startups: ISO vs NSO

For an early-stage SaaS, Biotech, or Deeptech startup, cash is runway and runway is life. Offering equity is a standard and powerful way to attract the top-tier talent you couldn't otherwise afford. But once you decide to create an employee stock option plan, you immediately face a critical choice: should you issue Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs)?

This decision isn't trivial. It establishes the tax and administrative foundation for your entire equity compensation strategy, with long-term consequences for both your company and your team. Making the wrong call can lead to unexpected tax bills for employees, compliance headaches for the company, and complexities that a lean startup can't afford. Understanding the difference between ISO and NSO stock options is essential for building a plan that motivates your team and supports your company's growth.

Stock Options Explained: The Core Mechanics

Before diving into the ISO vs. NSO debate, it is essential to understand the basic mechanics of any stock option. A stock option gives an employee the right, but not the obligation, to buy a certain number of company shares at a fixed price. This fixed price is called the strike price or exercise price, and it is determined on the day the options are granted.

This right is earned over time through a process called vesting. A typical vesting schedule for a startup employee is over four years with a one-year cliff. The cliff means no options are vested until the first anniversary of employment, at which point 25% of the total grant usually vests. The remainder then vests monthly or quarterly over the next three years.

Once options are vested, the employee can exercise them. This is the formal act of purchasing the shares at the predetermined strike price, regardless of the company's current valuation. For example, if an employee has vested options to buy 1,000 shares at a strike price of $1, and the company's stock is now valued at $10 per share, they can pay $1,000 to acquire stock worth $10,000. The $9,000 difference is their "paper gain." The tax treatment of this gain is the central difference between ISOs and NSOs.

The Core Difference Between ISO and NSO Stock Options

The fundamental distinction between ISOs and NSOs revolves around their tax treatment and eligibility rules. This creates the core trade-off between maximizing potential tax benefits for employees (ISOs) versus maintaining operational flexibility and securing a tax deduction for the company (NSOs).

Incentive Stock Options (ISOs): The Employee-Focused Choice

ISOs are a popular feature in many tech startup stock plans because they offer a significant potential tax advantage to employees. Under specific conditions, the profit from the options can be taxed at the lower long-term capital gains rate instead of the higher ordinary income tax rate. To qualify for this preferential treatment, the rules are strict.

To qualify for long-term capital gains tax treatment, ISO shares must be held for at least 1 year after exercising and 2 years after the grant date.

If these holding periods are met, the employee pays no tax at the time of exercise. They only pay tax when they eventually sell the shares. The entire gain, from the strike price to the final sale price, is taxed as a long-term capital gain. However, there are two major catches with ISOs that both companies and employees must understand.

The first is the Alternative Minimum Tax (AMT). When an employee exercises ISOs, the difference between the Fair Market Value (FMV) and their strike price, known as the bargain element, is not taxed as ordinary income, but it can trigger AMT. Consider a biotech startup engineer who exercises 10,000 vested options at a strike price of $0.50 when the 409A valuation places the FMV at $8.00. The bargain element is ($8.00 - $0.50) x 10,000 = $75,000. Even though the engineer hasn't sold the shares and has received no cash, this $75,000 paper gain is treated as income for AMT purposes and could trigger a significant tax bill for that year. This creates a cash flow problem, as the employee needs to pay taxes on a gain they have not yet realized in cash.

The second catch involves strict eligibility rules. ISOs can only be granted to W-2 employees of the company or its subsidiaries, and they must be US taxpayers. Furthermore, there is a key limitation on how many ISOs can be granted.

$100,000 limit on the value of ISOs that can vest for an employee in any calendar year; any amount over this is treated as an NSO

This limit is calculated based on the strike price. For example, if an employee has a grant where options with a strike price value of $120,000 are scheduled to vest in a single year, the first $100,000 worth can be treated as ISOs, but the remaining $20,000 worth will automatically be treated as NSOs. For the startup, the primary downside is clear: the company gets no corporate tax deduction when an employee exercises an ISO.

Non-Qualified Stock Options (NSOs): The Flexible, Company-Focused Choice

NSOs offer far greater flexibility, making them a vital tool for startup equity compensation. Unlike ISOs, they can be granted to anyone providing services to the company: employees, directors, advisors, consultants, and international team members. This is a critical distinction for modern startups that rely on a global talent pool or a network of expert contractors.

The tax treatment for NSOs is more straightforward for both the recipient and the company. The tax event occurs at exercise. For NSOs, the employee stock options tax is calculated immediately.

The 'bargain element' (difference between FMV and strike price at exercise) is taxed as ordinary income to the employee.

This amount is subject to federal and state income taxes as well as payroll taxes (Social Security and Medicare). The company is responsible for withholding these taxes, just like regular salary. While this means a larger immediate tax event for the recipient compared to an ISO, it creates a major advantage for the company.

In practice, we see this is a key reason companies choose NSOs for a portion of their equity plan. Specifically, for the company, there is a clear benefit.

The company gets a tax deduction equal to the ordinary income recognized by an NSO holder upon exercise.

For a startup nearing or achieving profitability, this deduction can be very valuable, reducing the company's overall tax liability. This direct financial benefit, combined with the flexibility to grant NSOs to anyone, makes them an indispensable part of a comprehensive equity strategy.

A Practical Framework for Choosing Your Option Type

The reality for most Pre-Seed to Series B startups is more pragmatic than an all-or-nothing decision. The best approach to startup equity compensation is often a hybrid one. Your choice should be driven by who you are granting equity to and your primary goals for the plan.

Choose ISOs when:

• Your recipients are exclusively US-based, W-2 employees.
• Your primary goal is to offer the most tax-advantaged equity compensation possible to attract and retain top US talent.
• You are prepared for the administrative overhead of tracking the $100k limit and ensuring compliance with holding periods.

Choose NSOs when:

• You need to grant equity to non-employees like contractors, advisors, or independent board members.
• You have international team members who are ineligible for ISOs.
• Simplicity in tax administration and securing a corporate tax deduction are high priorities for the company.

A common and effective strategy is to use both. A startup might issue ISOs to all its US employees up to the $100,000 annual vesting limit to maximize their potential tax benefits. For any value vesting above that limit in a given year, or for any grants made to non-employees, the company would issue NSOs. This hybrid approach allows the company to maximize the tax benefit for its US team while retaining the flexibility needed to compensate its entire contributor base.

Common Pitfalls in Managing Startup Stock Option Plans

Setting up a stock option plan introduces new operational risks. Missteps can create tax liabilities for your team and legal headaches for the company. Here are the most common pitfalls to avoid.

1. Invalid or Stale 409A Valuations

This is the most critical compliance task. The strike price of your options must be set at or above the company's Fair Market Value (FMV) on the date of grant. Getting this wrong can result in severe tax penalties for the employee.

Section 409A of the tax code requires an option's strike price to be at or above the Fair Market Value (FMV) on the date of grant

To establish a "safe harbor" FMV, you must obtain a formal 409A valuation from an independent, qualified provider. This is not optional. Remember, this valuation has an expiration date.

A 409A valuation is valid for a maximum of 12 months, or until a 'material event' like a new funding round occurs

A material event can include signing a term sheet, a significant change in financial projections, or a major secondary transaction. You must diarize your valuation renewal and trigger a new one immediately after closing a new round of financing before issuing new grants.

2. Misclassifying Recipients

A frequent mistake is granting ISOs to individuals who are not eligible US employees. An advisor who receives a 1099 tax form is a contractor, not an employee, and is therefore ineligible for ISOs. This error automatically invalidates the ISO, converting it to an NSO. This can create tax withholding failures for the company and confusion for the recipient. Always verify employment status (W-2 vs. 1099) before issuing any grants.

3. Inadequate Documentation

In the early days, founders managing everything on spreadsheets can easily fall behind on paperwork. Every option grant requires formal board approval, which must be documented in official board minutes. Each recipient must receive and sign a formal stock option grant agreement outlining the terms. This documentation is crucial for your company's accounting, future audits, and due diligence in fundraising rounds or an acquisition. Auditors will expect a clean paper trail. Proper

Accounting for stock-based compensation is governed by ASC 718 under US GAAP

This standard requires meticulous records of all grants, modifications, and exercises. Failing to maintain these records can create significant delays and costs during critical transactions.

Your Action Plan: Setting Up a Compliant Stock Option Plan

Choosing between ISOs and NSOs is a foundational decision for your startup's compensation strategy. The difference between ISO and NSO stock options boils down to a trade-off: potential tax advantages for US employees (ISOs) versus operational flexibility and a corporate tax deduction (NSOs).

For most early-stage US tech startup stock plans, a hybrid approach provides the best of both worlds. It allows you to offer tax-advantaged ISOs to your core US employee team while using flexible NSOs for everyone else, including key advisors, contractors, and international talent.

Before you proceed, here are your essential first steps:

1. Engage Legal Counsel: This article provides a framework, but an experienced startup lawyer is required to draft your formal stock option plan documents and individual grant agreements. This is not a DIY task.
2. Obtain a 409A Valuation: This is a non-negotiable first step. Before you can grant a single option, you need an independent valuation to set a compliant strike price.
3. Define Your Compensation Philosophy: Decide as a founding team if you are optimizing for employee tax benefits or for company simplicity and tax advantages. This will guide your mix of ISOs and NSOs and how you communicate the plan to candidates.
4. Create a Tracking System: Whether in a dedicated cap table management platform or a meticulously managed spreadsheet, establish a reliable system for tracking board approvals, grant dates, vesting schedules, and exercises. This discipline will pay dividends during future financing and audits.

For more guidance on structuring your plan, see our Share Option Schemes hub for broader design principles.

Frequently Asked Questions

Q: What is the difference between exercising an option and selling the stock?
A: Exercising is the act of purchasing shares at your fixed strike price. You then become a shareholder. Selling is the separate act of selling those shares on a market, hopefully for a profit. For ISOs, the time between exercise and sale is critical for determining the final stock option tax treatment.

Q: What happens to my options if I leave the company?
A: Typically, you have a limited time after leaving, known as the post-termination exercise period (PTEP), to exercise your vested options. This is often 90 days. If you don't exercise within this window, you forfeit the options. Some startups are extending this period to be more founder-friendly, but 90 days remains common.

Q: Can the Alternative Minimum Tax (AMT) on ISOs be avoided?
A: Avoiding AMT entirely can be difficult, but it can be managed. An employee can manage their AMT liability by exercising fewer options in a given year to stay under the AMT threshold, or by exercising and selling the shares in the same calendar year (a "disqualifying disposition"), which converts the gain to ordinary income but avoids the AMT cash crunch.

Q: Why are NSOs better for consultants and international team members?
A: The main reason is eligibility. US tax law explicitly states that ISOs can only be granted to employees. Consultants, advisors, and board members are not employees, making them ineligible. Similarly, international team members are typically not US employees for tax purposes, so they must receive NSOs or other forms of equity.